Summary of Key Points from BOE Financial Stability Report

The Bank of England's Financial Stability Report offers a timely assessment of the losses on key financial assets being experienced by the UK, US and euro-zone. Between the three areas, the losses today are around $2.8 trillion. In local currency terms, the losses of each center have roughly doubled in the past six months.

In the UK, estimates of total losses on 5 categories of assets (prime residential, non-conforming residential mortgage backed securities, commercial mortgage backed securities, investment grade corporate bonds and high yield corporate bonds) are near GBP122.6 bln vs the April estimate of GBP62.7 bln. Contrary to what one might intuitively expect, the losses suffered from corporate bond exposure (both investment grade and high yield corporate bonds) account for a full three quarters of the mark-to-market estimated losses.

In the US, the BOE's report estimates overall losses have risen to $1.577 trillion from the April estimate of $738 bln. Although the residential and commercial related exposures get the headlines, the BOE's figures warn that US financial institutions have another problem rivaling the mortgage-related losses. Investment grade and high yield bond exposures account for $847 bln of the overall loss or a little more than half.

The BOE's report shows the mark-to-market losses in the euro-zone have risen to 784.6 bln euros from 344.1 bln in April. It is true that euro-zone financial institutions have modest exposure to mortgage-related securities, but its exposure to corporate bonds accounts for a little more than 90% of the estimated losses.

The losses are of course significant. One key issue is what fraction of assets these losses account for. It varies from asset class to asset class. In the UK, for example, the GBP17.4 bln losses on prime residential mortgage backed securities is only about 9%. In the investment grade corporate bond exposure, the losses of GBP86.5 bln is nearly 20% of its GBP450 bln exposure.

In the US, losses on home equity loan asset back securities is about 41% of the $757 bln of assets. On the other hand, in the investment corporate bond sector, losses of $600 bln is less than 20% (~18%) of the $3.3 trillion exposure.

In the euro-zone, the 38.9 bln euro loss on residential mortgage backed securities of 387 bln euros amounts to 10%. The 643 bln euro loss being recorded on investment grade corporate bonds is 12% of the 5.32 trillion euro holdings. Losses of a larger percentage of assets are being recorded in the collateralized loan obligations (22%) and high yield corporate bonds (43%).

One metric to consider is that given these losses, how much new funds are officials providing. In the euro-zone for example, the individual sovereign bank recapitalization efforts amount to about 236 bln euros or about 30% of the mark-to-market estimated losses. Most of the programs the US had announced seem to be largely like asset-swaps (Treasuries for less liquid securities) and guarantees. Still some $250 bln of the TARP and some of the CP backstop and the (increasing) loan to AIG should be counted as what in Japan's crisis was called "real water". Still even being liberal with what is "real water" the US probably has provided probably less than a third of the $1.577 trillion. The UK appears to have provided about a third of the mark-to-market losses. In addition to the sovereign's assistance, US banks had appeared to raise a greater amount of capital by tapping foreign sovereign wealth funds, and other investors (e.g. Buffet).

Another way to try to get one's hands around the issue is to consider that the IMF's study of financial crisis found that the average banking crisis (the average may be of limited value given the great variance, but it is a starting point) cost about 16% of GDP. For the euro-zone, US, and UK economies combined, this is roughly equivalent to $4.4 trillion.